Institutional investors often use Volume Weighted Average Prices (VWAPs) to gauge whether they obtained a good price on a large order they sent to a sell-side trader. In the context of institutional trading, the “buy-side” refers to large investors (such as mutual funds) that ‘buy’ trading services from broker-dealers and the like. The “sell-side” refers to those broker-dealers and other types of traders that sell a service of buying and selling securities such as stock.
For example, consider a mutual fund manager who would like to purchase 1 million shares of a security. Releasing such a large order for the security to the market at one time might cause the market in the security to move against the order. Thus, to avoid this, the manager of the mutual fund may send such a buy order to a sell-side trader who “works the order,” e.g., executing several buy orders over several hours. At some point, the order is filled. The mutual fund manager can determine that the sell-side trader obtained an average price of, e.g., $25, for shares over all of the buy orders in the security. However, the mutual fund manager may want to know whether the $25 average price was a good price for that order at that time. The only readily available benchmark that exists which can be used by the manager to access if it received a good average price is the volume weighted average price of all transactions that occurred during the period (VWAP).